CFD Pairs Trading Examples

In this section we will introduce you to pairs trading and related strategies, with particular reference to research, testing and implementation

Contract for Differences pairs trading occurs when taking positions – one long and one short – in two CFDs usually in the same industry sector. The objective of this strategy is to exploit a perceived future convergence or divergence in the underlying share prices. It is not necessary for each position to yield a profit – only for the profit on one to exceed a potential loss on the other. This strategy is market neutral meaning the director of the overall market should not affect its profit or loss.

For example, Barclays Bank is due to announce it’s latest dividend and technical analysis suggests that the near term trend is positive. At the same time, Standard Chartered Bank is failing to establish upside momentum, falling victim to concerns over the SARS virus due to it’s heavy Asian market exposure. It is therefore decided to go long Barclays and sell short Standard – at EXACTLY the same time and in EXACTLY the same underlying value for each CFD;

The performance of a CFD Pairs trade is easily measured in terms of the ratio of the share prices. An increase from the original ratio will indicate a profit whilst a reduction in the ratio will indicate a losing trade.

Please note that while this type of intra-market strategy (i.e. CFD pairs trading) may be considered as lower risk than establishing a single CFD open position – this is mathematically misleading. Maintaining a spread position represents two open positions – one of which by definition is of a potentially unlimited contingent liability (the short sale). Therefore, in the above example the actual value at risk (VAR) – or definable rather than perceived risk – is much greater than even the sum of the two parts (£50,000).

Royal Dutch Petroleum and Shell Transport & Trading are two halves of the same company. Royal Dutch trades on the Amsterdam Stock Exchange, while Shell trades in London. In theory, their share prices should go up and down in unison.

If a gap develops between the two because Royal Dutch rises further than Shell (lowering the dividend yield), you should feel confident that the anomaly will correct itself sooner or later. In that case, you could sell a Royal Dutch CFD and buy a Shell CFD.

An investor anticipates that the share price of Royal Dutch Petroleum will outperform that of Shell Transport & Trading and -:

The opening margin required for this pairs trade would be £18,000 (10% of the aggregate Contract Values).

Scenario 1

The price of Royal Dutch Petroleum rises to 930p and Shell Transport & Trading rises to 609p.The price ratio is then 930/609 = 1.527.If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit
on Royal Dutch Petroleum trade

£3,000

(10,000
shares x (930-900))

Loss on Shell Transport & Trading trade

£(1,350)

(15,000
shares x (600-609))

Net
Profit on the Trade

£1,650

Scenario 2

The price of Royal Dutch Petroleum rises to 910p and Shell Transport & Trading rises to 640p.

The price ratio is then 910/640 = 1.422.

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit
on Royal Dutch Petroleum trade

£1,000

(10,000
shares x (910-900))

Loss on Shell Transport & Trading trade

£(6,000)

(15,000
shares x (600-640))

Net
Loss on the Trade

£(5,000)

Scenario 3

The price of Royal Dutch Petroleum falls to 850p while Shell Transport & Trading falls to 585p.

The price ratio is then 850/585 = 1.453.

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Loss
on Royal Dutch Petroleum trade

£(5,000)

(10,000
shares x (850-900))

Profit
on Shell Transport & Trading trade

£2,250

(15,000
shares x (600-585))

Net
Loss on the Trade

£(2,750)

Scenario 4

The price of Royal Dutch Petroleum falls to 870p and Shell Transport & Trading falls to 535p.

The price ratio is then 870/535 = 1.626.

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Loss
on Royal Dutch Petroleum trade

£(3,000)

(10,000
shares x (870-900))

Profit
on Shell Transport & Trading trade

£9,750

(15,000
shares x (600-535))

Net
Profit on the Trade

£6,750

Scenario 5

The price of Royal Dutch Petroleum rises to 910p and Shell Transport & Trading falls to 535p.

The price ratio is then 910/535 = 1.701

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Profit
on Royal Dutch Petroleum trade

£1,000

(10,000
shares x (910-900))

Profit
on Shell Transport & Trading trade

£9,750

(15,000
shares x (600-535))

Net
Profit on the Trade

£10,750

Scenario 6

The price of Royal Dutch Petroleum falls to 880p and Shell Transport & Trading rises to 635p.

The price ratio is then 880/635 = 1.386.

If the two CFDs were closed at these prices, the result, in monetary terms, would be:

Lost
on Royal Dutch Petroleum trade

(£2,000)

(10,000
shares x (880-900))

Loss
on Shell Transport & Trading trade

(£5,250)

(15,000
shares x (635-600))

Net
Loss on the Trade

(£7,250)

The beauty of the strategy is that it doesn’t matter whether the market rises or falls since the outcome of the trade simply relies on the relative movement of the two shares.

Another excellent low-risk example involves the two different classes of Schroder shares: SDR (voting) and SDRC (non-voting). Being different share classes of the same company makes this more akin to an arbitrage strategy.

The non-voting stocks typically trade at a discount of 4% to 12% and when this widens it creates an ideal pairs trading opportunity, but the key is to trade the less liquid non-voters first to make sure that this position is safely in place. Another popular combination is Enterprise Inns (ETI) and Punch Taverns (PUB).
Where the long and the short CFD positions are taken out with matching monetary exposures the resultant pairs trade will be market neutral. Since the stocks should be highly correlated with each other this will mean the risk of a pair could be 30% to 40% less than an equivalent uncovered position. Some CFD providers will take this into account and will reduce the margin requirement for an active client who regularly makes this type of trade. A pairs trade is not however the same as a hedge as there is still a big exposure if both positions go wrong. In view of this it may be best used when something triggers an overreaction to knock the stocks out of sync.

Disadvantages of Pairs Trading

Successful pairs trading depends on the trader’s ability to spot anomalies in the market and to act quickly on them. These anomalies may persist for long periods, or, as is usually the case, disappear very quickly. It can take time to identify the price anomalies, as well as some discretion to determine when to enter and exit trades. These price anomalies do not occur very often, so it is important to have a solid plan to spot them and then to take the appropriate action when they do appear. Pairs trading results in double commissions being paid to the CFD provider since these trades involve two positions.

It is also important to have a stop loss in place, even when trading pairs. Unforseen events such as takeover bids, unexpected company announcements, profit downgrades and other market related events can have an unexpected adverse impact on one leg of the pairs trade. A point of exit, either as a set percentage or a set dollar amount, needs to be determined before entering the trade.